**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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| **ý**                                                                                                                                                                                                                                                                             |   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                   |   |                                                                                                |
| **For the quarterly period ended  March 31, 2004**                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                                   |   |                                                                                                |
| **OR**                                                                                                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                                   |   |                                                                                                |
| **o**                                                                                                                                                                                                                                                                                  |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                                                                                                                                                                                                                                                   |   |                                                                                                |
| **For the transition period from                      to                    ** |

 

**Commission File Number  0-20191**

 

**INTRUSION INC.**

(Exact name of Registrant as specified in itscharter)

 

| **Delaware**                                                    |   | **75-1911917**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**1101 East Arapaho Road, Richardson, Texas75081**

(Address of principal executive offices)

(Zip Code)

 

**(972) 234-6400**

(Registrant’s telephone number, includingarea code)

 

**Not Applicable**

Former name, if changed since last report)

 

* * * * * * * * * *

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days:

Yes ý  No o

 

Indicate by check mark whether the Registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).  Yes o  No ý

 

The number of shares outstanding of the Registrant’s Common Stock,$0.01 par value, on April 30, 2004 was 5,166,312.

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I -  FINANCIAL INFORMATION**                                                                       |                                                                                        |
|-----------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|
|                                                                                                      |                                                                                        |
| Item 1.                                                                                                   | Financial Statements                                                                        |   |
|                                                                                                      |                                                                                        |
| Condensed  Consolidated Balance Sheets as of March 31, 2004 and  December 31, 2003              |                                                                                        |
|                                                                                                      |                                                                                        |
| Condensed  Consolidated Statements of Operations for the three months  ended March 31, 2004 and 2003 |                                                                                        |
|                                                                                                      |                                                                                        |
| Condensed Consolidated  Statements of Cash Flows for the three months  ended March 31, 2004 and 2003 |                                                                                        |
|                                                                                                      |                                                                                        |
| Notes to Condensed Consolidated Financial  Statements                                                     |                                                                                        |
|                                                                                                      |                                                                                        |
| Item 2.                                                                                                   | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   |
|                                                                                                      |                                                                                        |
| Item 3.                                                                                                   | Quantitative and Qualitative Disclosures About  Market Risk                                 |   |
|                                                                                                      |                                                                                        |
| Item 4.                                                                                                   | Controls and Procedures                                                                     |   |
|                                                                                                      |                                                                                        |
| **PART II -  OTHER INFORMATION**                                                                          |                                                                                        |
|                                                                                                      |                                                                                        |
| Item 1.                                                                                                   | Legal  Proceedings                                                                          |   |
|                                                                                                      |                                                                                        |
| Item 2.                                                                                                   | Changes in  Securities, Use of Proceeds and Issuer Purchases of Equity Securities           |   |
|                                                                                                      |                                                                                        |
| Item 4.                                                                                                   | Submission  of Matters to a Vote of Security Holders                                        |   |
|                                                                                                      |                                                                                        |
| Item 6.                                                                                                   | Exhibits and Reports on Form 8-K                                                            |   |
|                                                                                                      |                                                                                        |
| Signature Page                                                                                            |                                                                                        |

 

2

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**PARTI****- FINANCIAL INFORMATION**

 

Item 1.             FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(In thousands, except par value amounts)

 
|                                                                                                                                                              |   | **March 31,  2004** |   | **December 31,  2003** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-----------------------------|--------|
|                                                                                                                                                              |   | **(Unaudited)**          |   | **(Audited)**               |   |
| **ASSETS**                                                                                                                                                        |   |                     |   |                        |   |
| Current Assets:                                                                                                                                                   |   |                     |   |                        |   |
| Cash and cash equivalents                                                                                                                                         |   | $                        | 5,787  |                        | $      | 974 |   |
| Short-term investments                                                                                                                                            |   | 505                      |   | 1,705                       |   |
| Accounts receivable, less allowance for  doubtful accounts $574 in 2004 and $574 in 2003                                                                          |   | 498                      |   | 972                         |   |
| Inventories, net                                                                                                                                                  |   | 1,481                    |   | 1,286                       |   |
| Other assets                                                                                                                                                      |   | 402                      |   | 449                         |   |
| Total  current assets                                                                                                                                             |   | 8,673                    |   | 5,386                       |   |
| Property and equipment, net                                                                                                                                       |   | 234                      |   | 297                         |   |
| Other assets                                                                                                                                                      |   | 77                       |   | 77                          |   |
| TOTAL ASSETS                                                                                                                                                      |   | $                        | 8,984  |                        | $      | 5,760 |   |
|                                                                                                                                                              |   |                     |   |                        |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                     |   |                     |   |                        |   |
|                                                                                                                                                              |   |                     |   |                        |   |
| Current Liabilities:                                                                                                                                              |   |                     |   |                        |   |
| Accounts payable and accrued expenses                                                                                                                             |   | $                        | 1,875  |                        | $      | 2,188 |   |
| Deferred revenue                                                                                                                                                  |   | 867                      |   | 788                         |   |
| Total current liabilities                                                                                                                                         |   | 2,742                    |   | 2,976                       |   |
| Stockholders’ Equity:                                                                                                                                        |   |                     |   |                        |   |
| Preferred stock, $.01 par value, authorized  shares - 5,000 - 1,000 shares issued and outstanding, net of discount                                                |   | 3,534                    |   | —                      |   |
| Common stock, $.01 par value, authorized  shares - 80,000; issued shares - 5,176 in 2004 and 5,173 in 2003; outstanding  shares - 5,166 in 2004 and 5,163 in 2003 |   | 52                       |   | 52                          |   |
| Common stock held in treasury, at cost - 10  shares                                                                                                               |   | (362                     | )      | (362                        | )      |
| Additional paid-in capital                                                                                                                                        |   | 48,723                   |   | 47,526                      |   |
| Accumulated deficit                                                                                                                                               |   | (45,477                  | )      | (44,204                     | )      |
| Accumulated other comprehensive loss                                                                                                                              |   | (228                     | )      | (228                        | )      |
| Total stockholders’ equity                                                                                                                                   |   | 6,242                    |   | 2,784                       |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                   |   | $                        | 8,984  |                        | $      | 5,760 |   |

 

See accompanying notes.

 

3

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**INTRUSION INC. AND SUBSIDIARIES**

CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS

(In thousands,except per share amounts)

(Unaudited)

 
|                                                                        |   | **Three  Months Ended**  |   |
|-----------------------------------------------------------------------------|--------|--------------------------|--------|
|                                                                        |   | **March 31,  2004** |   | **March 31,  2003** |   |
| Net revenues                                                                |   | $                        | 1,267  |   | $ | 1,476 |   |
|                                                                        |   |                     |   |   |   |
| Cost of revenues                                                            |   | 637                      |   | 1,004 |   |
|                                                                        |   |                     |   |   |   |
| Gross profit                                                                |   | 630                      |   | 472 |   |
|                                                                        |   |                     |   |   |   |
| Operating expenses:                                                         |   |                     |   |   |   |
| Sales and marketing                                                         |   | 960                      |   | 1,863 |   |
| Research and development                                                    |   | 601                      |   | 923 |   |
| General and administrative                                                  |   | 264                      |   | 402 |   |
| Severance costs                                                             |   | 96                       |   | 126 |   |
|                                                                        |   |                     |   |   |   |
| Operating loss                                                              |   | (1,291                   | )      | (2,842 | ) |
|                                                                        |   |                     |   |   |   |
| Interest income, net                                                        |   | 18                       |   | 61 |   |
|                                                                        |   |                     |   |   |   |
| Loss before income tax provision                                            |   | (1,273                   | )      | (2,781 | ) |
|                                                                        |   |                     |   |   |   |
| Income tax provision                                                        |   | —                   |   | — |   |
|                                                                        |   |                     |   |   |   |
| Net loss                                                                    |   | $                        | (1,273 | ) | $ | (2,781 | ) |
|                                                                        |   |                     |   |   |   |
| Beneficial conversion feature on preferred  stock                           |   | (938                     | )      | — |   |
| Net loss attributable to common stockholders                                |   | $                        | (2,211 | ) | $ | (2,781 | ) |
|                                                                        |   |                     |   |   |   |
| Net loss per share attributable to common  stockholders (basic and diluted) |   | $                        | (0.43  | ) | $ | (0.54 | ) |
|                                                                        |   |                     |   |   |   |
| Weighted average common shares outstanding,  basic and diluted              |   | 5,163                    |   | 5,162 |   |

 

See accompanying notes.

 

4

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**INTRUSION INC. AND SUBSIDIARIES**

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 
|                                                                        |   | **Three  Months Ended**  |   |
|-----------------------------------------------------------------------------|--------|--------------------------|--------|
|                                                                        |   | **March 31,  2004** |   | **March 31,  2003** |   |
| Operating Activities:                                                       |   |                     |   |   |   |
| Net loss                                                                    |   | $                        | (1,273 | ) | $ | (2,781 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities |   |                     |   |   |   |
| Depreciation and amortization                                               |   | 104                      |   | 445 |   |
| Changes in operating assets and  liabilities:                               |   |                     |   |   |   |
| Accounts receivable                                                         |   | 474                      |   | 807 |   |
| Inventories                                                                 |   | (195                     | )      | (315 | ) |
| Other assets                                                                |   | 48                       |   | (38 | ) |
| Accounts payable and accrued expenses                                       |   | (314                     | )      | (165 | ) |
| Deferred revenue                                                            |   | 80                       |   | (361 | ) |
| Net cash used in operating activities                                       |   | (1,076                   | )      | (2,408 | ) |
| Investing Activities:                                                       |   |                     |   |   |   |
| Purchases of short-term investments                                         |   | —                   |   | (1,000 | ) |
| Maturities of short-term investments                                        |   | 1,200                    |   | 1,525 |   |
| Net purchases of property and equipment                                     |   | (42                      | )      | (70 | ) |
| Net cash provided by investing activities                                   |   | 1,158                    |   | 455 |   |
| Financing Activities:                                                       |   |                     |   |   |   |
| Proceeds from the exercise of employee  stock options                       |   | 6                        |   | — |   |
| Proceeds from the issuance of preferred  stock and warrants, net            |   | 4,725                    |   | — |   |
| Net cash provided by financing activities                                   |   | 4,731                    |   | — |   |
|                                                                        |   |                     |   |   |   |
| Net increase(decrease) in cash and cash  equivalents                        |   | 4,813                    |   | (1,953 | ) |
| Cash and cash equivalents at beginning of  period                           |   | 974                      |   | 2,898 |   |
| Cash and cash equivalents at end of period                                  |   | $                        | 5,787  |   | $ | 945 |   |
|                                                                        |   |                     |   |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                  |   |                     |   |   |   |
|                                                                        |   |                     |   |   |   |
| Fair value of warrants issued in connection  with sale of preferred stock   |   | $                        | 1,191  |   | $ | — |   |
| Amortization of preferred stock beneficial  conversion feature              |   | $                        | 938    |   | $ | — |   |

 

See accompanying notes.

 

5

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1.          Descriptionof Business

 

We develop, market andsupport a family of network intrusion prevention and detection systems andregulated information compliance systems that address vital security issuesfacing organizations with mission critical business applications or housingclassified, confidential, or customer information assets.  We currently provide network security andregulated information compliance solutions under our SecureNet family of hardwareand software solutions.

 

We market and distributeour products through a direct sales force to end-users, distributors and bynumerous domestic and international system integrators, managed serviceproviders and value-added resellers. Our end-user customers include high technology, manufacturing,telecommunications, retail, transportation, health care, insurance,entertainment, utilities and energy companies, government entities, financialinstitutions, and academic institutions.

 

We were organized inTexas in September 1983 and reincorporated in Delaware inOctober 1995.  For more than 15years, we provided local area networking equipment and were known as OpticalData Systems or ODS Networks.  OnApril 17, 2000, we announced plans to sell, or otherwise dispose of, ournetworking divisions, which included our Essential Communications division andour local area networking assets.  Inaccordance with these plans, we have accounted for these businesses asdiscontinued operations.  OnJune 1, 2000, we changed our name from ODS Networks, Inc. to Intrusion.com,Inc., and our NASDAQ ticker symbol from ODSI to INTZ to reflect our focus onintrusion detection solutions.  OnNovember 1, 2001, we changed our name from Intrusion.com, Inc. toIntrusion Inc.

 

Our principal executiveoffices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400.  Ourwebsite URL is www.intrusion.com. Information contained in or linked to our website are not a part of thisreport.  References to “we,” “us” and“our” in this report refer to Intrusion Inc. and its subsidiaries.

 

As of March 31,2004, we had cash, cash equivalents and short-term investments in the amount ofapproximately $6.3 million, up from approximately $2.7 million as ofDecember 31, 2003.  Although webelieve we have sufficient cash resources to finance our operations andexpected capital expenditures for the next twelve months, the sufficiency ofour cash resources may depend to a certain extent on general economic,financial, competitive or other factors beyond our control.  Moreover, despite actions to reduce ourcosts and improve our profitability, we expect our operating losses and netoperating cash outflows to continue through at least the first half of 2004.  As a result, we may not be able to achievethe revenue and gross margin objectives necessary to achieve positive cash flowor profitability without obtaining additional financing.  We do not currently have any arrangementsfor financing and we may not be able to secure additional debt or equity financingon terms acceptable to us, or at all, at the time when we need suchfunding.  If our business does notgenerate sufficient cash flow from operations and sufficient future financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due or fund our other liquidity needs.

 

6

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On March 25, 2004,we completed a $5.0 million private placement of 5% Convertible Preferred Stockand warrants.  In the private placement,we sold 1,000,000 shares of preferred stock at a price of $5.00 per share forgross proceeds of $5.0 million, less $275,000 of issuance costs.  The preferred shares may be converted into1,590,331 shares of common stock at an initial conversion price of $3.144 pershare.  Included in this transactionwere warrants to purchase 556,619 shares of common stock at an exercise priceof $3.144 per share.  In connection withthe closing of this private placement, we issued warrants to purchase 64,408shares of our common stock at an exercise price of $3.144 per share to ourfinancial advisor for assistance with the private placement.

 

On March 18, 2004,we filed an amendment to our certificate of incorporation to effect afour-for-one (4:1) reverse stock split of our common stock.  The reverse stock split became effective onMarch 29, 2004.  All outstandingshare numbers and related common stock numbers, such as earnings per share andoutstanding options, included in this report are set forth on a post-split basis.

 

2.          Basisof Presentation

 

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States forcomplete financial statements.  TheDecember 31, 2003 balance sheet was derived from audited financialstatements, but does not include all the disclosures required by accountingprinciples generally accepted in the United States.  However, we believe that the disclosures are adequate to make theinformation presented not misleading. In our opinion, all the adjustments (consisting of normal recurringadjustments) considered necessary for fair presentation have beenincluded.  The results of operations forthe three months ending March 31, 2004 are not necessarily indicative ofthe results that may be achieved for the full fiscal year or for any futureperiod.  The condensed consolidatedfinancial statements included herein should be read in conjunction with theconsolidated financial statements and notes thereto included in the Company’sannual report on Form 10-K for the year ended December 31, 2003.

 

3.          Inventories(In thousands)

 

Inventories consist of:

 
|                  |   | **March 31,  2004** |   | **December 31,  2003** |   |
|-----------------------|--------|--------------------------|--------|-----------------------------|--------|
|                  |   |                     |   |                        |   |
| Finished goods        |   | $                        | 1,030  |                        | $      | 851 |   |
| Work in progress      |   | 252                      |   | 261                         |   |
| Demonstration systems |   | 199                      |   | 174                         |   |
| Net inventory         |   | $                        | 1,481  |                        | $      | 1,286 |   |

 

7

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4.          Accountingfor Stock-Based Compensation

 

We account for employee stock-basedcompensation under APB 25.  Thefollowing table summarizes relevant information as to the reported resultsunder our intrinsic value method of accounting for stock awards, withsupplemental information as if the fair value recognition provision of SFAS 123had been applied for the quarters ended March 31, 2004 and March 31,2003 (in thousands, except per share data). All such information is reported in post reverse stock split values:

 
|                                                                                                         |   | **March 31,  2003** |   | **March 31,  2003** |   |
|--------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|--------------------------|--------|
|                                                                                                         |   |                     |   |                     |   |
| Net loss attributable to common  stockholders                                                                |   | $                        | (2,211 | )                        | $      | (2,781 | ) |
| Add (deduct):  Total stock-based compensation determined under fair value-  based method for all awards |   | (72                      | )      | 332                      |   |
| Pro forma net loss attributable to common  stockholders                                                      |   | $                        | (2,283 | )                        | $      | (2,449 | ) |
| Net loss per share attributable to common  stockholders:                                                     |   |                     |   |                     |   |
| As reported (basic and diluted)                                                                              |   | $                        | (0.43  | )                        | $      | (0.54 | ) |
| Pro forma (basic and diluted)                                                                                |   | $                        | (0.44  | )                        | $      | (0.47 | ) |
| Weighted-average shares used in  computation:                                                                |   |                     |   |                     |   |
| Basic and Diluted                                                                                            |   | 5,163                    |   | 5,162                    |   |

 

As required, the proforma disclosures above include options granted since January 1,1995.  Consequently, the effects ofapplying SFAS 123 for providing pro forma disclosures may not be representativeof the effects on reported operating results for future years until all optionsoutstanding are included in the pro forma disclosures.  For purposes of pro forma disclosures, theestimated fair value of stock-based compensation plans and other options areamortized to expense primarily over the vesting period.

 

5.          Net Loss Per Share

 

We report two separateearnings per share (“EPS”) numbers, basic EPS and diluted EPS.  Basic net loss per share is computed bydividing net loss attributable to common stockholders for the period by theweighted average number of common shares outstanding for the period.  Diluted net loss per share is computed bydividing the net loss attributable to common stockholders by the weightedaverage number of common shares and common stock equivalents outstanding forthe period.  Our common stock equivalentsinclude all common stock issuable upon conversion of convertible preferredstock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the loss per share calculation for the three-month periodsended March 31, 2004 and 2003 are 2,609,715 and 404,652,respectively.  Our common stockequivalents are not included in the diluted loss per share for the three-monthperiods ended March 31, 2004 and 2003 as they are antidilutive.

 

8

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6.          Commitmentsand Contingencies

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters, if any, will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

During the quarter, wesuccessfully renegotiated our lease agreement for our headquarters inRichardson, Texas, which decreased the amount of square feet we lease andextended the lease term for an additional five years.  In accordance with the new lease agreement, our Richardson, Texasheadquarters will be located in the same building. However, we will reduce theamount of space that we lease from approximately 95,000 square feet toapproximately 30,000 square feet of floor space and the term of our new leasewill expire in February 2010.

 

7.          PreferredStock Private Placement

 

On March 25, 2004,we completed a $5.0 million private placement of 5% Convertible Preferred Stockand warrants.  In the private placement,we sold 1,000,000 shares of preferred stock at a price of $5.00 per share forgross proceeds of $5.0 million, less $275,000 of issuance costs.  The preferred shares may be converted into1,590,331 shares of common stock at an initial conversion price of $3.144 pershare.

 

The 5% dividends relatedto the preferred stock are paid semi-annually on the last business day inMarch and September of each year, beginning with September 2004.  Preferred stockholders vote together withcommon stockholders on an as converted to common stock basis.  Based on the conversion rate of thepreferred stock, holders of preferred stock will receive 1.5903 votes per shareand rounded to the nearest whole number. The liquidation preference for the preferred stock is an amount equal to$5.00 per share plus any accrued and unpaid dividends.  Holders of preferred stock have liquidationpreference rights over common stock holders.

 

Included in thistransaction were warrants to purchase 556,619 shares of common stock at anexercise price of $3.144 per share.  Inconnection with the closing of this private placement, we issued warrants topurchase 64,408 shares of our common stock at an exercise price of $3.144 pershare to our financial advisor for assistance with the private placement.  These 621,027 shares from warrants werevalued at $1.2 million using the Black-Scholes model and have been treated as adiscount to the Preferred Stock and were recorded as an increase in additionalpaid in capital.  The issuance of thewarrants resulted in a beneficial conversion feature to the Preferred Stockvalued at $0.9 million.  The amortizationof the beneficial conversion feature is deducted from the net loss to arrive atthe net loss attributed to common stockholders.

 

The Preferred Stock wasrecorded as the net of the financing proceeds of $5.0 million less $275,000issuance costs and the fair value of the warrants issued in conjunction withthe Preferred Stock of $1.2 million.

 

We have the right toredeem any or all of the outstanding preferred stock at a price of $5.00 pershare plus accrued dividends at any time after September 25, 2004 ifcertain conditions are met.

 

9

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Item 2.                                                             MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS

 

This report containsforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning: the difficulties in forecastingfuture sales caused by current economic and market conditions, the effect ofmilitary actions on government and corporate spending on information securityproducts, spending patterns of, and appropriations to, U.S. governmentdepartments, the impact of our cost reduction programs and our refocusedproduct line, the difficulties and uncertainties in successfully developing andintroducing new products, our ability to continue to meet operating expensesthrough current cash flow or additional financings, the continuance andstrength of our relationship with Check Point, the highly competitive marketfor our products, difficulties in accurately estimating market growth, theconsolidation of the information security industry, the impact of changingeconomic conditions, business conditions in the information security industry,our ability to manage acquisitions effectively, our ability to managediscontinued operations effectively, the impact of market peers and theirproducts as well as risks concerning future technology and others identified inour Annual Report on Form 10-K and other Securities and Exchange Commissionfilings.  Such forward-lookingstatements are generally accompanied by words such as “plan,” “estimate,”“expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or otherwords that convey uncertainty of future events or outcomes.  These forward-looking statements and otherstatements made elsewhere in this report are made in reliance on the PrivateSecurities Litigation Reform Act of 1995. The section below entitled “Factors That May Affect Future Resultsof Operations” sets forth and incorporates by reference certain factors thatcould cause actual future results of the company to differ materially fromthese statements.

 

CriticalAccounting Policies and Estimates

 

Management’s discussion and analysis offinancial condition and results of operations are based upon our condensedconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States.  The preparation of these financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those relatedto product returns, bad debts, inventories, income taxes, warranty obligations,restructuring, maintenance contracts and contingencies.  We base our estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believe the following critical accountingpolicies affect our more significant judgments and estimates used in thepreparation of our condensed consolidated financial statements.

 

10

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*Revenue Recognition*

 

We generally recognizeproduct revenue upon shipment of product. We accrue for estimated warranty costs, sales returns and otherallowances at the time of shipment based on our experience.  To date, warranty costs and sales returnshave not been material.  There is a riskthat technical issues on new products could result in unexpected warranty costsand returns.

 

We recognize softwarerevenue from the licensing of our software products in accordance withStatement of Position (“SOP”) 97-2 “Software Revenue Recognition” and SOP 98-9“Modification of 97-2, Software Revenue Recognition, with respect to certaintransactions” and Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition”whereby revenue from the licensing of our products is not recognized until allfour of the following have been met: i) execution of a written purchase order,license agreement or contract; ii) shipment of the product has occurred; iii)the license fee is fixed and determinable; and iv) collectibility isprobable.  The Company defers andrecognizes maintenance and support revenue over the term of the contractperiod, which is generally one year.

 

We have signeddistribution agreements with distributors in the United States, Europe andAsia.  In general, these relationshipsare non-exclusive.  Distributors typicallymaintain an inventory of our products. Under these agreements, we provide certain protection to thedistributors for their inventory of our products for price reductions as wellas products that are slow-moving or have been discontinued by us.  Recognition of sales to distributors andrelated gross profits are deferred until the merchandise is resold by thedistributors.  However, since we havelegally sold the inventory to the distributor and we no longer have care,custody or control over the inventory, we recognize the trade accountsreceivable and reduce inventory related to the sale at the time of shipment tothe distributor.  The deferred revenuein the accompanying financial statements is offset by deferred cost of sales.

 

*Allowance for Doubtful Accountsand Returns*

 

Tradeaccounts receivable are stated at the amount we expect to collect.  We maintain allowances for doubtful accountsfor estimated losses resulting from the inability of our customers to makerequired payments.  Management considersthe following factors when determining the collectibility of specific customeraccounts:  customer credit-worthiness,past transaction history with the customer, current economic industry trends,and changes in customer payment terms. If the financial condition of our customers were to deteriorate,adversely affecting their ability to make payments, additional allowances wouldbe required.  Based on management’sassessment, we provide for estimated uncollectible amounts through a charge toearnings and a credit to a valuation allowance.  Balances that remain outstanding after we have used reasonablecollection efforts are written off through a charge to the valuation allowanceand a credit to accounts receivable

 

*Inventory*

 

We write down our inventory for estimatedobsolescence or unmarketable inventory equal to the difference between the costof inventory and the estimated market value based upon assumptions about futuredemand and market conditions. If actual market conditions are less favorablethan those projected by management, additional inventory write-downs may berequired.

 

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Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 
|                                              |   | **Three  Months Ended**  |       |
|---------------------------------------------------|--------|--------------------------|------------|
|                                              |   | **March 31,  2004** |       | **March 31,  2003** |   |
| Net revenues                                      |   | 100.0                    | %          | 100.0 | % |
| Cost of revenues                                  |   | 50.3                     |       | 68.0 |   |
| Gross profit                                      |   | 49.7                     |       | 32.0 |   |
| Operating expenses:                               |   |                     |       |   |   |
| Sales and marketing                               |   | 75.8                     |       | 126.2 |   |
| Research and development                          |   | 47.4                     |       | 62.5 |   |
| General and administrative                        |   | 20.8                     |       | 27.2 |   |
| Severance costs                                   |   | 7.6                      |       | 8.5 |   |
| Operating loss                                    |   | (101.9                   | )          | (192.4 | ) |
|                                              |   |                     |       |   |   |
| Interest income, net                              |   | 1.4                      |       | 4.1 |   |
| Loss before income tax provision                  |   | (100.5                   | )          | (188.3 | ) |
|                                              |   |                     |       |   |   |
| Income tax provision                              |   | —                   |       | — |   |
|                                              |   |                     |       |   |   |
| Net loss                                          |   | (100.5                   | )%         | (188.3 | )% |
| Beneficial conversion feature on preferred  stock |   | (74.0                    | )          | — |   |
|                                              |   |                     |       |   |   |
| Net loss attributable to common  stockholders     |   | (174.5                   | )%         | (188.3 | )% |
|                                              |   |                     |       |   |   |
|                                              |   | **Three  Months Ended**  | ** ** |
|                                              |   | **March 31,  2004** |       | **March 31,  2003** | ** ** |
| Domestic revenues                                 |   | 67.5                     | %          | 48.4 | % |
| Export revenues to:                               |   |                     |       |   |   |
| Europe                                            |   | 24.8                     |       | 37.3 |   |
| Canada                                            |   | 2.6                      |       | (0.7 | ) |
| Asia                                              |   | 5.1                      |       | 15.0 |   |
|                                              |   |                     |       |   |   |
| Net revenues                                      |   | 100.0                    | %          | 100.0 | % |

 

**NetRevenues**.  Netrevenues for the quarter ended March 31, 2003 decreased to $1.3 millioncompared to $1.5 million for the same period of 2003 as revenues from our firstgeneration security products decreased. In addition, continued sluggish economic conditions and delayed customerorders contributed to the decline in revenues.

 

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**ExportRevenues**.  Exportrevenues for the quarter ended March 31, 2004 decreased to $0.4 millioncompared to $0.8 million for the same period of 2003 as revenues from our PDSsecurity appliance family decreased and we focused more of our resourcesdomestically.

 

**Concentrationof Revenues**.  Revenuesfrom Concurrent Technologies Corporation were 20.0% of revenues for the quarterended March 31, 2004, compared to 0.0% for the same period of 2003.  Revenues from Expedia Inc. were 11.5% ofrevenues for the quarter ended March 31, 2004, compared to 0.0% for thesame period of 2003.  Revenues from theU.K. Government were 1.5% of total revenues for the quarter endedMarch 31, 2004, compared to 11.4% for the same period of 2003.  We expect the concentration of revenues tocontinue with various customers, but that the particular customers will varydepending upon the timing of certain revenues in future quarters.

 

**GrossProfit**.  Gross profitwas $0.6 million or 49.7% of net revenues for the quarter ended March 31,2004, compared to $0.5 million or 32.0% of net revenues for the quarter endedMarch 31, 2003. Gross profit margins as a percentage of net revenuesincreased from the same period in the prior year due to a continued shift inproduct mix, which resulted in an increase as a percentage of revenues of ourmore profitable SecureNet product line.

 

Gross profit as a percentageof net revenues is impacted by several factors, including shifts in productmix, changes in channels of distribution, revenues volume, fluctuations inthird-party assembly costs, pricing strategies, and fluctuations in revenues ofintegrated third-party products.

 

**Salesand Marketing**.  Salesand marketing expenses decreased to $1.0 million for the quarter endedMarch 31, 2004, compared to $1.9 million for the quarter endedMarch 31, 2003, primarily due to the reorganization of our sales andmarketing departments, including a reduction in headcount, and other costreduction initiatives.  We expect tocontinue to realize the impact of our cost reduction initiatives throughout2004.  Sales and marketing expenses mayvary as a percentage of net sales in the future.  However, we believe that these costs will remain constant throughthe end of the year.

 

**Researchand Development**. Research and development expenses decreased to $0.6 million for thequarter ended March 31, 2004, compared to $0.9 million for the quarterended March 31, 2003. Research and development costs are expensed in theperiod incurred.  Research anddevelopment expenses decreased in the quarter ended March 31, 2004,compared to the same period in 2003 as we focused more of our development effortson our core security products, SecureNet and our Information Complianceproducts, while reducing efforts on our other security products. Research anddevelopment expenses may vary as a percentage of net sales in the future.

 

**Generaland Administrative**. General and administrative expenses decreased to $0.3 million for thequarter ended March 31, 2004, compared to $0.4 million for the quarterended March 31, 2003, primarily due to the restructuring done in 2003,including a reduction in headcount, and other cost reduction initiatives.  It is expected that general andadministrative expenses will remain relatively constant throughout theremainder of the year.  General and administrativeexpense may vary as a percentage of net sales in the future.

 

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**SeveranceCosts. **Severancecosts of $0.1 million for the three-month period ended March 31, 2004consists primarily of severance payments made after year-end as a result ofreductions in force.  All severance obligations were paidprior to March 31, 2004, and we were not receiving further benefit fromthe severed individuals after March 31, 2004.  Severance costs of $0.1 million for the three-month periodended March 31, 2003 consisted of reductions in force made during thatperiod.

 

**Interest**.  Net interest income decreased to $18thousand for the quarter ended March 31, 2004 compared to $61 thousand forthe same period in 2003.  The slightdecrease in interest income was primarily due to the reduced overall cashbalances resulting from operating losses. Net interest income may vary in the future based on our cash flow andrate of return on investments.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at March 31, 2004 is approximately $5.8 million of cash and cashequivalents and $0.5 million of short-term investments.  As of March 31, 2004 working capitalwas $5.9 million compared to $8.3 million as of March 31, 2003.

 

On March 25, 2004,we completed a $5.0 million private placement of 5% Convertible Preferred Stockand warrants.  In the private placement,the Company sold 1,000,000 shares of preferred stock at a price of $5.00 pershare, which may be converted into 1,590,331 shares of common stock at aninitial conversion price of $3.144 per share, and warrants to purchase 556,615shares of common stock at an exercise price of $3.144 per share.  In connection with the closing of thisprivate placement, we issued warrants to purchase 64,409 shares of our commonstock at an exercise price of $3.144 per share to our financial advisor for theprivate placement.

 

Cash used in operationsfor the three months ended March 31, 2004 was $1.1 million, primarily dueto an operating loss of $1.3 million, an increase in inventories and a decreasein accounts payable and accrued expenses, which is offset by depreciationexpense and a decrease in accounts receivable and an increase in deferredrevenue, compared to cash used in operations of $2.4 million for the threemonths ended March 31, 2003, primarily due to an operating loss fromcontinuing operations of $2.8 million, which is offset by depreciation expenseand a decrease in accounts receivable. Future fluctuations in inventory balances, accounts receivable and accountspayable will be dependent upon several factors, including, but not limited to,quarterly sales, our strategy in building inventory in advance of receivingorders from customers, and the accuracy of our forecasts of product demand andcomponent requirements.

 

Cash provided ininvesting activities in the three months ended March 31, 2004 was $1.2million, which consisted primarily of the net maturity of short-terminvestments, compared to cash provided by investing activities of $0.5 millionfor the three months ended March 31, 2003, which also consisted primarilyof the maturity of short-term investments.

 

Cash provided byfinancing activities in the three months ended March 31, 2004 was $4.7million, consisting of net financing proceeds from a private placement and theexercise of employee stock options, compared to $0.0 million during the threemonths ended March 31, 2003.

 

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At March 31, 2004,the Company did not have any material commitments for capital expenditures.

 

During the three monthsended March 31, 2004, the Company funded its operations through the use ofcash and cash equivalents.

 

Although we believe wehave sufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months, the sufficiency of our cash resourcesmay depend to a certain extent on general economic, financial, competitive orother factors beyond our control. Moreover, despite actions to reduce our costs and improve our profitability,we expect our operating losses and net operating cash outflows to continue atleast through the first half of 2004. As a result, we may not be able to achieve the revenue and gross marginobjectives necessary to achieve positive cash flow or profitability withoutobtaining additional financing.  We donot currently have any arrangements for financing, and we may not be able tosecure additional debt or equity financing on terms acceptable to us, or atall, at the time when we need such funding. If our business does not generate sufficient cash flow from operationsand sufficient future financings are not available, we may not be able tooperate or grow our business, pay our expenses when due or fund our otherliquidity needs.

 

We intend to explore thepossible acquisitions of businesses, products and technologies that arecomplementary to our existing business. We are continuing to identify and prioritize additional securitytechnologies which we may wish to develop, either internally or through the licensingor acquisition of products from third parties. While we engage from time to time in discussions with respect topotential acquisitions, there can be no assurances that any such acquisitionswill be made or that we will be able to successfully integrate any acquiredbusiness.  In order to finance suchacquisitions and working capital it may be necessary for us to raise additionalfunds through public or private financings. Any equity or debt financings, if available at all, may be on terms,which are not favorable to us and, in the case of equity financings, may resultin dilution to our stockholders.

 

Factors That May AffectFuture Results of Operations 

 

Numerous factors mayaffect our business and future results of operations.  These factors include, but are not limited to, current economicand market conditions, the effect of military actions on government andcorporate spending on information security products, spending patterns of, andappropriations to, U.S. government departments, technological changes,competition and market acceptance, acquisitions, product transitions, timing oforders, manufacturing and suppliers, reliance on outsourcing vendors and otherpartners, intellectual property and licenses, third-party products, dependenceon government customers, international operations, intellectual propertyissues, liquidity and cash resources and effects of restructuring plans andcost reductions.  The discussion belowaddresses some of these and other factors. For a more thorough discussion of these and other factors that may affectour business and future results, see the discussion under the caption “FactorsThat May Affect Future Results of Operations” in our Annual Report on Form 10-Kfor the year ended December 31, 2003.

 

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**RISKS RELATED TO OUR BUSINESS**

 

**We resemble a developmental stage company and ourbusiness strategy may not be successful. **Fromour founding in 1983 until 2000, we derived substantially all of our revenuefrom the design, manufacture and sale of local area networkingtelecommunications equipment.  In orderto permit us to focus our resources solely on developing and marketing ournetwork security products, on April 17, 2000, we announced our plans tosell our local area networking assets and related networking divisions.

 

As a result of these sales, we now depend exclusively onrevenues generated from the sale of our networks security products, which havereceived limited market acceptance. Moreover, we have only recently introduced our regulated informationcompliance systems, which have no established market.  Consequently, we resemble a developmental stage company and willface the following inherent risks and uncertainties:

 

•                  the need for our network securityproducts and regulated information compliance systems to achieve marketacceptance and produce a sustainable revenue stream;

 

•                  our ability to manage costs andexpenses;

 

•                  our dependence on key personnel;

 

•                  our ability to obtain financing onacceptable terms; and

 

•                  our ability to offer greater valuethan our competitors.

 

Our business strategy may not successfully address theserisks.  If we fail to recognizesignificant revenues from the sales of our network security products andregulated information compliance systems, our business, financial condition andoperating results would be materially adversely affected.

 

**We have incurred significant net losses and maynever achieve profitability. **We have incurred significantoperating losses and are uncertain about our future operating results.  For the quarter ended March 31, 2004,we incurred a net loss of $1.3 million and had an accumulated deficit ofapproximately $45.5 million.  We need togenerate and sustain substantially greater revenues from the sales of ourproducts if we are to achieve profitability. If we are unable to achieve these greater revenues, our losses willcontinue indefinitely, and we may never achieve or sustain profitability orgenerate positive cash flow.

 

**Our financial results vary from quarter toquarter and may not meet expectations. **Our operating results have variedsignificantly from quarter to quarter in the past, and we expect our operatingresults to vary from quarter to quarter in the future due to a variety offactors, many of which are outside of our control.  Although our revenues are subject to fluctuation, significantportions of our expenses are not variable in the short term, and we cannotreduce them quickly to respond to decreases in revenues.  Therefore, if revenues are below ourexpectations, this shortfall is likely to adversely and disproportionatelyaffect our operating results. Accordingly we may not attain positive operating margins in futurequarters.  Any of these factors couldcause our operating results to be below the expectations of securities analystsand investors, which likely would negatively affect the price of our commonstock.

 

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**We may not receive the expected benefits or ourrecent cost reduction efforts. **During the first quarter of 2004, wecontinued a restructuring plan and cost reduction efforts, which resulted in$0.1 million in severance costs.  Sincewe began our restructuring initiatives in 2002, we have incurred approximately$0.8 million in restructuring charges, severance costs and relatedexpenses.  The objective of ourrestructuring plan was to reduce our cost structure to a sustainable level thatis consistent with our current cash resources and the general economic climate.  We have also implemented other strategicinitiatives to strengthen our operations, such as reductions in our work forceand facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results ofour initiatives could seriously harm our business, results of operations andfinancial condition.

 

**Our products may not achieve marketacceptance. **Over the past three years, we havetransitioned our sales strategy from our lower margin SecureCom and PDSsecurity appliance products to the development and sales of our higher marginSecureNet network intrusion detection products.  During this transition, sales of our new products were not enoughto counteract the loss in sales associated with our older products.  As a result, our net revenues have declinedfrom approximately $16.7 million in 2001, to approximately $7.8 million in 2002and approximately $6.5 million in 2003. In addition, our revenues for the first quarter of 2004 are $1.3 millionas compared to $1.5 million for the same period in 2003.

 

Ournew network security products and regulated information compliance systems haveonly been in the market place for a limited period of time and may have longersales cycles than our previous products. Although response to our products has been positive, we have not yetreceived broad market acceptance.  Wecannot assure you that our present or future products will achieve marketacceptance on a sustained basis.

 

Inorder to achieve market acceptance and achieve future revenue growth, we mustintroduce complementary security products, incorporate new technologies intoour existing product lines and design, develop and successfully commercializehigher performance products in a timely manner.  We cannot assure you that we will be able to offer new orcomplementary products that gain market acceptance quickly enough to avoiddecreased revenues during current or future product introductions ortransitions.

 

**We derive a significant portion of our revenuefrom sales to government entities. **For the quarter ended March 31,2004, we derived 34.5% of our revenues from sales to various U.S. governmententities, either directly by us or indirectly through system integrators andother resellers, and we expect to continue to derive a substantial portion ofour revenues from U.S. government customers in the future.  Sales to the government present risks inaddition to those involved in sales to commercial customers, includingpotential disruption due to appropriation and spending patterns and thegovernment’s right to cancel contracts and purchase orders for itsconvenience.  General political andeconomic conditions, which we cannot accurately predict, directly andindirectly may affect the quantity and allocation of expenditures by federaldepartments.  In addition, obtaininggovernment contracts may involve long purchase and payment cycles, competitivebidding, qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also 

 

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maintainsits own rules and regulations with which we must comply and which can varysignificantly among departments.  As aresult, cutbacks or re-allocations in the federal budget or losses ofgovernment sales due to other factors could have a material adverse effect onour revenues and operating results.

 

**We derive a substantial portion of our revenuefrom international sales. **Sales to foreign customers accountedfor approximately 32.5% of our revenues for the quarter ended March 31,2004, and we expect sales to foreign customers to continue to represent asignificant portion of our revenues in the future.  Our international operations are subject to many inherent risksthat may adversely affect our business, financial condition and operatingresults, including:

 

•                  political, social and economicinstability;

 

•                  trade restrictions;

 

•                  increases in duty rates and otherpotentially adverse tax consequences;

 

•                  exposure to different legalstandards, particularly with respect to the protection of intellectualproperty;

 

•                  burdens of complying with a varietyof foreign laws;

 

•                  unexpected changes in regulatoryrequirements;

 

•                  import and export license requirementsand restrictions of the United States and each other country where we operate;

 

•                  fluctuations in currency exchangerates; and

 

•                  changes in local purchasingpractices, including seasonal fluctuations in demand.

 

**Our sales to foreign customers may be subjectto export regulations. **Certain of our data securityproducts incorporate encryption and other technology that may require clearanceand export licenses from the U.S. Department of Commerce under United Statesexport regulations.  Any inability to obtainthese clearances or licenses or any foreign regulatory approvals, if required,on a timely basis could delay sales and have a material adverse effect on ouroperating results.

 

**We depend on our relationship with Check PointSoftware Technologies.**** Our PDS family of security appliances, which are integrated withCheck Point Software Technologies’ market-leading VPN-1®/FireWall-1® software,represented 4.6% of our revenues for the quarter ended March 31, 2004, adecline from 25.7% of our revenues for the quarter ended March 31,2003.  We expect the percentage of oursales attributable to our PDS products to decline in the future; however, ourreliance on newer product sales may not replace the anticipated decline inrevenue from sales of our PDS products. Although we are a certified appliance partner of Check Point and our PDSproducts have received Check Point certification, we have no long-termagreement or exclusive relationship with Check Point.  As a result, the loss or significant change in our relationshipwith Check Point, the failure of our PDS products to maintain or receive CheckPoint certification, the business failure of Check Point or its acquisition byor of one of our competitors and the loss of market share of Check Point ormarket acceptance of its products could 

 

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eachhave a material adverse effect on our business, financial condition and resultsof operations.

 

**We rely on third party manufacturers. **Our operational strategy relies on outsourcing product assemblyand certain other manufacturing operations to third parties.  Therefore, our ability to introduce productsand product enhancements depends on these manufacturers to achieve rapid volumeproduction of these new products.  If weare unable to effectively manage our third-party manufacturers or if thesemanufacturers fail to provide us with adequate supplies of high-qualityproducts in a timely manner, our reputation and results of operations wouldsuffer.

 

**We may experience shortages in components andmaterials. **We purchase all of the componentsand other materials used in our products under contracts or purchase orderswith third parties.  While we believethat many of the materials we use are readily available from a variety ofsources, certain components such as microprocessors and motherboards areavailable from one or a limited number of suppliers.  The lead times for delivery of components vary significantly andcan exceed twelve weeks for components. If we fail to forecast our requirements for components accurately, wemay experience excess inventory or shortages of certain components that couldhave an adverse effect on our business and operating results.  Further, any interruption in the supply ofany of these components, or our inability to procure these components fromalternative sources at acceptable prices within a reasonable time, could havean adverse effect on our business and operating results.

 

**We have long sales and implementationcycles. **The sale and implementation of ourproducts to large companies and government agencies typically involves alengthy education process and a significant technical evaluation and commitmentof capital and other resources.  Thisprocess is also subject to the risk of delays associated with customers’internal budgeting and other procedures for approving capital expenditures,deploying new technologies within their networks and testing and accepting newtechnologies that affect key operations. As a result, sales and implementation cycles for our products can belengthy, and we may expend significant time and resources before we receive anyrevenues from a customer or potential customer.  Our quarterly and annual operating results could be materiallyharmed if orders forecasted for a specific customer for a particular period arenot realized.

 

**We must expand our sales through, and receive theanticipated benefits from our sales to, indirect sales channels. **We believe we must expand our sales through indirect saleschannels, such as distributors, value added resellers, system integrators,original equipment manufacturers and managed service providers, in order toincrease our revenues.  Although we areactively pursuing a strategy to increase the percentage of our revenuesgenerated through these indirect sales channels, we cannot assure you that ourproducts will gain market acceptance in these indirect sales channels or thatsales through these indirect sales channels will increase our revenues asexpected.  Further, many of our competitorsare also trying to sell their products through these indirect sales channels,which could result in lower prices and reduced profit margins for sales of ourproducts.

 

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**Military actions may disrupt our business. **United States military actions or other events occurring inresponse to or in connection with them, including future terrorist attacks,actual conflicts involving the United States or its allies or military or tradedisruptions could impact our operations by:

 

•                  reducing or delaying government orcorporate spending on network security products;

 

•                  increasing the cost and difficultyin obtaining materials or shipping products; and

 

•                  affecting our ability to conductbusiness internationally.

 

Should these events occur, our business, operating results andfinancial condition could be materially and adversely affected.

 

**We may acquire complementary products orbusinesses. **We have made acquisitions in thepast, and, in the future, we may acquire or invest in additional companies,business units, product lines or technologies to accelerate the development ofproducts and sales channels complementary to our existing products and saleschannels.  Negotiation of potentialacquisitions and integration of acquired products, technologies or businessescould divert our management’s time and resources.  Future acquisitions could cause us to issue equity securitiesthat would dilute your ownership of us, incur debt or contingent liabilities,amortize intangible assets or write off in-process research and development,goodwill and other acquisition-related expenses that could seriously harm ourfinancial condition and operating results. Further, if we are not able to properly integrate acquired products, technologiesor businesses with our existing products and operations, train, retain andmotivate personnel from the acquired business or combine potentially differentcorporate cultures, we may not receive the intended benefits of ouracquisitions, which could adversely affect our business, operating results andfinancial condition.

 

**We must adequately protect our intellectualproperty. **We rely on a combination of patent,copyright, trademark and trade secret laws, confidentiality procedures andnon-disclosure agreements to protect our proprietary technology.  However, unauthorized parties may attempt tocopy or reverse engineer aspects of our products or to obtain and useinformation that we regard as proprietary. Policing unauthorized use of our products is difficult, and we cannot becertain that the steps we have taken will prevent misappropriation of ourintellectual property.  This isparticularly true in foreign countries where the laws may not protect proprietaryrights to the same extent as the laws of the United States and may not provideus with an effective remedy against unauthorized use.  If our protection of our intellectual property proves to beinadequate or unenforceable, others may be able to use our proprietarydevelopments without compensation to us, resulting in potential cost advantagesto our competitors.

 

**We incorporate third party products into ourproducts. **We believe it is beneficial to workwith third parties with complementary technologies to broaden the appeal of oursecurity products.  These alliancesallow us to provide integrated solutions to our customers by combining ourtechnology with third party products. The operation of our products could be impaired if errors or defectsoccur in the third party products we use. It may be more difficult for us to correct any defects or errors inthird party products because their development and maintenance is outside ofour control.  Accordingly, our businesscould be adversely affected in the event of any errors or defects in these products.

 

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Wecannot assure you that third parties will continue to make their productsavailable to us on acceptable terms. Furthermore, it may be difficult to us to replace any third partyproduct if a vendor seeks to terminate our license to the product or ourability to license the product to our customers.  Any impairment in our relationship with these third parties couldadversely impact our business, results of operations and financial condition.

 

**We could become subject to claims ofinfringement. **There are numerous patents held bymany companies relating to the design and manufacture of network securitysystems.  Although we are not aware ofany instances in which our products violate the intellectual property rights ofothers or inappropriately use their technology, it is possible that thirdparties in the future may claim that our products infringe on theirintellectual property rights.  Anyclaim, with or without merit, could consume our management’s time, result incostly litigation, cause delays in sales or implementations of our products orrequire us to enter into royalty or licensing agreements.  Royalty and licensing agreements, ifrequired and available, may be on terms unacceptable to us or detrimental toour business.  Moreover, a successfulclaim of product infringement against us or our failure or inability to licensethe infringed or similar technology on commercially reasonable terms could seriouslyharm our business.

 

**We must attract and retain key personnel. **We rely upon the continued service of a relatively small numberof key technical, sales and senior management personnel.  Our future success depends on retaining ourkey employees and our continuing ability to attract, train and retain otherhighly qualified technical, sales and managerial personnel.  We have employment agreements withrelatively few**of our keytechnical, sales and senior management personnel.  As a result, our employees could resign with little or no priornotice.  We may not be able to attract,assimilate or retain other highly qualified technical, sales and managerialpersonnel in the future, especially given our recent reductions in force.  The loss of any of our key technical, salesand senior management personnel or our inability to attract, train and retainadditional qualified personnel could seriously harm our business.

 

## **RISKS RELATED TO OUR INDUSTRY**

 

**We must respond to rapid technological changesin the network security industry. **The network security industry ischaracterized by frequent product introductions, rapidly changing technologyand continued evolution of new industry standards.  We must also introduce upgrades to our products rapidly inresponse to customer needs such as new computer viruses or other novel externalattacks on computer networks.  Inaddition, the nature of the network security industry requires our products tobe compatible and interoperable with numerous security products, networkingproducts, workstation and personal computer architectures and computer andnetwork operating systems offered by various vendors, including ourcompetitors.  As a result, our successdepends upon our ability to develop and introduce in a timely manner new productsand enhancements to our existing products that meet changing customerrequirements and evolving industry standards. The development oftechnologically advanced network security products is a complex and uncertainprocess requiring high levels of innovation, rapid response and accurate anticipationof technological and market trends.  Wecannot assure you that we will be able to identify, develop, manufacture,market or support new or enhanced products successfully in a timely manner.  Further, we or our competitors may introducenew products or product enhancements that shorten the life cycle of ourexisting products or cause our existing products to become obsolete.

 

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**We face intense competition. **The market for network security solutions is intenselycompetitive. There are numerous companies competing with us in various segmentsof the data security markets, and their products may have advantages over ourproducts in areas such as conformity to existing and emerging industrystandards, interoperability with networking and other security products,management and security capabilities, performance, price, ease of use,scalability, reliability, flexibility, product features and technical support.

 

Our principle competitors in the network intrusion and detectionmarket include Internet Security Systems, Inc., Cisco Systems, Inc., Symantec,Inc., Netscreen Technologies, Inc., Tipping Point Technologies Inc. and NFRSecurity, Inc.  The market for regulatedinformation compliance systems is relatively new.  Our competitors in this market include a number of start upcompanies that have entered the market in the last two years.  However, as this market develops, we expectincreased competition from both start up and established companies.  Our current and potential competitors mayhave one or more of the following significant advantages over us:

 

•                  greater financial, technical andmarketing resources;

 

•                  better name recognition;

 

•                  more comprehensive securitysolutions;

 

•                  better or more extensive cooperativerelationships; and

 

•                  larger customer base.

 

Although we believe that our focus on network perimeters withmarket leading VPN/firewall control technology and network intrusion detectionvisibility technology that reduce the total cost of ownership provides us withan advantage with large organizations with complex security requirements, wecannot assure you that our products will achieve market acceptance or that wewill be able to compete successfully with our existing or new competitors.

 

**Consolidation in the network security industrymay harm our business. **Several of our competitors haveacquired security companies with complementary technologies in the past, and weexpect consolidation in the network security industry to continue in thefuture.  These acquisitions may permitour competitors to accelerate the development and commercialization of broaderproduct lines and more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit ouraccess to commercially significant technologies.  Further, business combinations in the network security industryare creating companies with larger market share, customer bases, sales forces,product offerings and technology and marketing expertise, which may make itmore difficult for us to compete.

 

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## **RISKS RELATED TO OUR STOCK**

 

**You will experience substantial dilution upon theconversion of the shares of preferred stock and exercise of warrants that weissued in a private placement. **On March 25, 2004, we completeda $5,000,000 private placement in connection with which we issued 1,000,000shares of our 5% Convertible Preferred Stock and warrants to acquire 556,619shares of our common stock.  Theconversion price for the preferred stock and the exercise price of the warrantsis $3.144 per share.  We also issued ourplacement agent a warrant for 64,408 shares of our common stock at an exerciseprice of $3.144 per share.  As a result,we expect the private placement to result in dilution to holders of our commonstock upon conversion of the preferred stock and exercise of the warrants of2,221,358 shares of common stock, or an approximately 43% increase in the numberof shares of our common stock outstanding.

 

**The conversion of preferred stock or exercise ofwarrants we issued in the private placement may cause the price of our commonstock to decline. **The holders of preferred stock andwarrants we issued in the private placement will be able to freely converttheir shares of preferred stock and exercise their warrants and sell theirunderlying shares of common stock upon the effectiveness of the registrationstatement we filed relating to those shares of common stock.  For the four weeks ended on May 7, 2004, theaverage daily trading volume of our common stock on The Nasdaq SmallCap Marketwas 32,720 shares.  Consequently, ifholders of preferred stock or warrants elect to convert their shares orexercise their warrants and sell a material amount of their underlying sharesof common stock on the open market, the increase in selling activity couldcause a decline in the market price of our common stock.  Furthermore, these sales, or the potentialfor these sales, could encourage short sales, causing additional downwardpressure on the market price of our common stock.

 

**Certain rights of the holders of 5% convertiblepreferred stock may hinder our ability to raise additional financing. **We cannot issue shares of capital stock with rights senior tothose of our existing preferred or incur certain indebtedness without theapproval of at least a majority of the holders of our 5% convertible preferredstock.  In addition, holders of thepreferred stock who are not executive officers or directors have the right topurchase a pro rata portion of certain future issuances of securities byus.  The combination of these provisionscould hinder or delay our ability to raise additional debt or equity financing.

 

**Payment of dividends on our 5% convertiblepreferred stock may strain our cash resources. **Sharesof our 5% convertible preferred stock accrue cash dividends equal to $0.25 pershare per annum.  These dividends arepayable in arrears on March 31 and September 30 of each year,commencing on September 30, 2004. Delaware law provides that we may only pay dividends out of our capitalsurplus or, if no surplus is available, out of our net profits for the fiscalyear the dividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years, and as of March 31, 2004 our capital surplus, defined as theamount by which our net assets exceed our stated capital, was approximately$2.7 million.  Therefore, we have onlylimited resources to pay these dividends. In addition, the payment of these dividends could strain our availablecash resources, which could adversely affect our ability to operate or grow ourbusiness.

 

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**The price of our common stock has beenvolatile. **The market price of our common stockhas been highly volatile in the past and may continue to be volatile in thefuture.  For example, sinceApril 30, 2003, the market price of our common stock on The Nasdaq SmallCapMarket has fluctuated between $1.00 and $5.52 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside our control, including:

 

•                  variations in our quarterlyoperating results;

 

•                  changes in estimates of ourfinancial performance by securities analysts;

 

•                  changes in market valuations of ourcompetitors;

 

•                  announcements by us or ourcompetitors of new products, significant contracts, acquisitions, strategicrelationships, joint ventures or capital commitments;

 

•                  product or design flaws, productrecalls or similar occurrences;

 

•                  additions or departures of keypersonnel;

 

•                  sales of common stock in the future;and

 

•                  fluctuations in stock market pricesand volume, which can be particularly common among network security and otherhigh technology companies.

 

**Provisions of our charter documents and Delawarelaw may have anti-takeover effects. **Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our stockholders to act by writtenconsent, could make it more difficult for a third party to acquire us, even ifdoing so would be beneficial to our stockholders.  We are also subject to the provisions of Section 203 of theDelaware General Corporation Law, which restricts certain business combinationswith interested stockholders and could inhibit a non-negotiated merger or otherbusiness combination.

 

**Our management and larger stockholders exercisesignificant control over our company. **As of April 30, 2004, ourexecutive officers, directors and 5% stockholders beneficially ownapproximately 38.5% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influenceto approve or take actions that may be adverse to your interests.

 

Item3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

**ForeignExchange**.  Revenueoriginating outside the U.S. in the quarters ended March 31, 2004 and 2003was 32.5% and 51.6% of total revenues, respectively. International sales aremade mostly from our foreign sales subsidiaries in the local countries and aretypically denominated in U.S. dollars. These subsidiaries incur most of their expenses in the local currency.

 

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Our internationalbusiness is subject to risks typical of an international business, including,but not limited to: differing economic conditions, changes in politicalclimate, differing tax structures, other regulations and restrictions andforeign exchange rate volatility. Accordingly, our future results could be materially adversely affectedby changes in these or other factors. The effect of foreign exchange rate fluctuations on us in 2004 and 2003was not material.

 

On January 1, 2003, the Company elected to change thefunctional currency of its foreign operations to the United States dollar. Thischange in functional currency is supported by the fact that all foreignoperations are funded monthly in United States dollars and the majority of arevenue contracts are denominated in United States dollars.  Under United States dollar functionalcurrency, the financial statements of foreign locations are remeasured from therecording currency to the United States dollar. The resulting remeasurementadjustment is recorded as foreign exchange gain or loss in the statement ofoperations. There is no translation adjustment to the separate component ofstockholders’ equity or adjustment to comprehensive income. The effect of thechange in functional currency had no material impact on results of operations.The accumulation of prior years’ translation adjustments remains on the balancesheet as a separate component of stockholders’ equity until part, or all, ofthe respective entities are disposed.

 

**InterestRates**. We invest our cash in a variety of financialinstruments, including bank time deposits, fixed rate obligations ofcorporations, municipalities, and state and national governmental entities andagencies.  These investments aredenominated in U.S. dollars.  Cashbalances in foreign currencies overseas are operating balances and are investedin short-term time deposits of the local operating bank.

 

Interest income on ourinvestments is carried in “Interest income, net”.  We account for our investment instruments in accordance with SFASNo. 115, “Accounting for Certain Investments in Debt and EquitySecurities”.  All of the cashequivalents and short-term investments are treated as available-for-sale underSFAS 115.

 

Investments in fixed rateinterest earning instruments carry a degree of interest rate risk.  Fixed rate securities may have their fairmarket value adversely impacted due to a rise in interest rates.  Due in part to these factors, our futureinvestment income may fall short of expectations due to changes in interestrates or we may suffer losses in principal if forced to sell securities, whichhave seen a decline in market value due to changes in interest rates.  Our investment securities are held forpurposes other than trading.  Theweighted-average of the stated coupon interest rate on investment securities atMarch 31, 2004 was 5.83%.  Due tothe amortization of premiums and discounts paid, the actual rate of return willvary from the weighted-average of the stated coupon interest rate.  The fair value of investments held atMarch 31, 2004 approximated amortized cost.

 

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Item 4.                                                             CONTROLS AND PROCEDURES

 

We have carried out an evaluation, under thesupervision and the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of ourdisclosure controls and procedures as of March 31, 2004, pursuant to Rule13a-15(b) under the Exchange Act.  Basedupon that evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures are effective in ensuringthat information required to be disclosed is recorded, processed, summarizedand reported in a timely manner.

 

We have carried out anevaluation, under the supervision and participation of our management,including our Chief Executive Officer and Chief Financial Officer, of anychanges in our internal controls over financial reporting that occurred duringthe quarterly period ended March 31, 2004, and our Chief Executive Officerand Chief Financial Officer have concluded that there was no change during thequarterly period ended March 31, 2004 that has materially affected or isreasonably expected to materially affect our internal control over financialreporting.

 

**PARTII****- OTHER INFORMATION**

 

Item 1.                                                             LEGALPROCEEDINGS

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

 

Item 2.                                                             CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUERPURCHASES OF EQUITY SECURITIES

 

(a)                                  OnMarch 18, 2004, we filed an amendment to our certificate of incorporationto effect a four-for-one (4:1) reverse stock split which became effective onMarch 29, 2004.  As a result of thesplit, every four (4) shares of our common stock outstanding as of the close ofbusiness on March 26, 2004, were combined into one (1) share of commonstock on March 29, 2004.  We didnot issue any fractional shares in connection with the reverse stocksplit.  Instead all fractional shareswere rounded up to the nearest whole share. We did not change the authorized number of shares of our common stock,the par value of our common stock, the rights of holders of common stock to one(1) vote per share held, or any of the other rights, preferences or privilegesof our common stock in connection with the reverse split.

 

(b)                                 OnMarch 25, 2004, we filed a certificate of designation to create our 5%convertible preferred stock, which consists of 1,000,000 authorized shares andhas the rights, preferences and privileges summarized below.

 

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**Dividends**.  Holders of preferred stock are entitled to a5% per annum dividend per share.  Thedividend accrues and is payable in cash semi-annually on the last business dayof March and September.  Accruedbut unpaid dividends are also payable upon the conversion or redemption of theshares of preferred stock and upon a liquidation event.  If we are in default in the payment of thedividends on the preferred stock, we cannot declare or pay any dividends onshares of common stock.

 

**VotingRights**.  Holders ofpreferred stock vote together with shares of common stock on an as converted tocommon stock basis.  Based on theconversion rate of the preferred stock, holders of shares of preferred stockwill receive 1.5903 votes for each share. After aggregating all voting rights of a particular holder, anyfractional votes are rounded to the nearest whole number.  As a result, a holder of 100 shares ofpreferred stock would be entitled to 159 votes on any matters submitted to ourstockholders for approval.  Based on the1,000,000 shares of preferred stock outstanding and the 5,166,312 shares ofcommon stock outstanding as of April 30, 2004, the preferred stock constitutesapproximately 23.5% of our outstanding voting power.

 

In addition, as long asany shares of preferred stock are outstanding, we cannot take any of thefollowing actions without the separate class vote or written consent of amajority of the then outstanding shares of preferred stock:

 

•                                          redeem, repurchase or acquire forvalue any shares of the preferred stock other than pursuant to the conversionand redemption provisions of the preferred stock;

 

•                                          redeem, repurchase or acquire forvalue any shares of our common stock other than under agreements pursuant towhich we have the right to repurchase common stock from employees, officers,directors, consultants and other service providers upon their termination orother events at a price no greater than the original cost of the shares plusinterest at no more than 9% per annum as long as the total amount we repurchasedoes not exceed $100,000 in any 12-month period; or

 

•                                          issue any debt securities or incurindebtedness for borrowed money, other than in connection with a strategiccommercial agreement approved by our board of directors, pursuant to acommercial borrowing, secured lending or lease financing transaction approvedby our board of directors or in connection with an acquisition.

 

**Conversion**.  The preferred stock, which is comprised ofan aggregate of 1,000,000 authorized shares, is convertible, at the option ofthe holders, into shares of our common stock at an initial conversion price of$3.144 per share.  Based on the originalpurchase price of $5.00 per share, each share of preferred stock is initiallyconvertible into 1.5903 shares of our common stock.  The preferred stock contains adjustment provisions upon theoccurrence of stock splits, stock dividends, combinations, reclassifications orsimilar events of our capital stock.

 

A holder of preferred stock cannot convert shares of preferredstock into shares of our common stock if that holder would beneficially owngreater than 9.9% of our issued and outstanding shares of common stock, asdetermined in accordance with Section 13(d) of the Exchange Act, uponconversion of the preferred stock.

 

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**Redemption**.  We have the right to redeem any or all ofthe outstanding shares of preferred stock at a price of $5.00 per share plusany accrued but unpaid dividends at any time after September 25, 2004 ifthe following conditions are met:

 

•                                          the volume weighted average price ofour common stock for ten consecutive trading days must be at least 200% of theconversion price of the preferred stock then in effect, for a period of any 20out of 30 consecutive trading days immediately preceding the redemption;

 

•                                          the shares of common stockunderlying the shares of preferred stock can be sold without restriction on resale;

 

•                                          the registration statement relatedto these preferred shares is effective at all times during the period beginningat least 30 days prior to our notice of redemption and ending on the earlier tooccur of the redemption date or the last date we are required to keep theregistration statement effective; and

 

•                                          the registration statement relatedto these preferred shares is expected to remain effective until the earlier of30 days following the earlier to occur of the redemption date and the last daywe are required to keep the registration effective.

 

**Rank;Liquidation Preference**. The holders of preferred stock rank prior to the holders of our commonstock and, unless otherwise consented to by the holders of preferred stock,prior to all other classes of capital stock currently outstanding, or that wemay establish, with respect to the distribution of our assets upon abankruptcy, liquidation or other similar event.  The liquidation preference for the preferred stock is an amountequal to $5.00 per share plus any accrued and unpaid dividends.

 

(c)                                  OnMarch 25, 2004, we completed a private placement under Rule 506 ofRegulation D in which sixinstitutional investors and three individual accredited investors, including G.Ward Paxton, our Chairman, President and Chief Executive Officer, and James F.Gero, a member of our Board of Directors, pursuant to which the investors paidus an aggregate of $5,000,000 in cash in consideration for (1) 1,000,000 sharesof our 5% convertible preferred stock convertible into shares of our commonstock at an initial conversion price of $3.144 per share and (2) warrants topurchase up to 556,619 shares of our common stock at an initial exercise priceof $3.144 per share. In addition, we issued Black Point Partners, Inc., our financial advisorin the private placement, a warrant to purchase 64,408 shares of our commonstock at an exercise price of $3.144 per share.  The shares of preferred stock currently are convertible into1,590,331 shares of our common stock. The conversion price of the preferredstock and the exercise price of the warrants are subject to adjustments forstock dividends, splits, combinations, reclassifications and similartransactions.  The investors in theprivate placement cannot convert shares of preferred stock into shares of ourcommon stock or exercise their warrants if that investor would beneficially owngreater than 9.9% of our issued and outstanding shares of common stock, asdetermined in accordance with Section 13(d) of the Exchange Act, after theconversion or exercise.

 

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ITEM 4.                                                     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

At a special meeting heldon March 18, 2004, our stockholders voted on a proposal to amend ourcertificate of incorporation to effect a four-for-one (4:1) reverse stock splitof our common stock as follows:

 

| **FOR**    |   | **AGAINST** |   | **ABSTAIN** |   |
|------------|--------|-------------|--------|-------------|--------|
| 19,102,921 |   | 470,164     |   | 30,481      |   |

 

Item 6.                                                             EXHIBITS ANDREPORTS ON FORM 8-K

 

(a)                                      The following Exhibits are filedwith this report form 10-Q:

 
| 2.1(1)  |   | Certificate of Ownership and Merger merging Intrusion.com, Inc. into  Intrusion Inc.                                                                                                                  |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(2)  |   | Amended and Restated Certificate of Incorporation of the Registrant.                                                                                                                                  |
| 3.2(3)  |   | Certificate of Amendment to Certificate of Incorporation of  Registrant                                                                                                                               |
| 3.3(4)  |   | Certificate of Designation for the Registrant’s 5% Convertible  Preferred Stock                                                                                                                  |
| 4.1(5)  |   | Specimen Common Stock Certificate                                                                                                                                                                     |
| 4.2(4)  |   | Specimen 5% Convertible Preferred Stock Certificate                                                                                                                                                   |
| 4.3(4)  |   | Form of Warrant to Purchase Shares of Common Stock                                                                                                                                                    |
| 4.4(4)  |   | Warrant to Purchase Common Stock dated March 25, 2004, issued by  the Registrant to Black Point Partners                                                                                         |
| 4.5(4)  |   | Registration Rights Agreement dated as of March 25, 2004, by and  among the Registrant and the entities listed on Schedule A thereto                                                        |
| 4.6(4)  |   | Form of Lock-Up Agreement                                                                                                                                                                             |
| 10.1(5) |   | Lease Agreement between CalWest Industrial Holdings Texas, L.P. and  Intrusion Inc.                                                                                                                   |
| 10.2(4) |   | Securities Purchase Agreement dated as of March 25, 2004, by and  among the Registrant and the purchasers listed on Exhibit A thereto.                                                           |
| 31.1(6) |   | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)  of the Exchange Act.                                                                                                             |
| 31.2(6) |   | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)  of the Exchange Act.                                                                                                             |
| 32.1(6) |   | Certification of Chief Executive Officer Pursuant to Rule 13a-14(b)  of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2(6) |   | Certification of Chief Financial Officer Pursuant to Rule 13a-14(b)  of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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(1)                                 Filed as an Exhibit to theRegistrant’s Definitive Proxy Statement on Schedule 14A in connection withthe solicitation of proxies for its 2002 Annual Meeting of Stockholders, whichExhibit is incorporated herein by reference.

 

(2)                                 Filedas an Exhibit to the Registrant’s Annual Report on Form 10-K for thefiscal year ended December 31, 2001, which Exhibit is incorporated hereinby reference.

 

(3)                                 Filedas an Exhibit to the Registrant’s Definitive Proxy Statement onSchedule 14A in connection with the solicitation of proxies for itsSpecial Meeting of Stockholders held March 18, 2004, which Exhibit isincorporated herein by reference.

 

(4)                                 Filedas an Exhibit to the Registrant’s Current Report on Form 8-K datedMarch 26, 2004, which Exhibit is incorporated herein by reference.

 

(5)                                 Filedas an Exhibit to the Registrant’s Annual Report on Form 10-K for the fiscalyear ended December 31, 2003, which Exhibit is incorporated herein byreference.

 

(6)                                 Filedherewith.

 

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(b)                                     During the quarter endedMarch 31, 2004, we filed the following reports on Form 8-K:

 

•                  Report onForm 8-K filed on March 26, 2004, announcing the effective date of afour-for-one reverse stock split of Intrusion common stock.

 

•                  Report onForm 8-K filed on March 25, 2004, announcing a Securities PurchaseAgreement with six institutional investors and three individual investors forconvertible preferred stock.

 

•                  Report onForm 8-K filed on March 18, 2004, announcing stockholder approval of afour-for-one reverse stock split.

 

•                  Report onForm 8-K filed on January 16, 2004, announcing that Intrusion received aNasdaq listing extension.

 

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**SI G N A T U R E S**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
|               |   |   |   | **INTRUSION INC.**                              |   |
|--------------------|--------|--------|--------|-------------------------------------------------|--------|
|               |   |   |   |                                            |   |
|               |   |   |   |                                            |   |
| Date: May 13, 2004 |   |   |   | /s/ Michael L. Paxton                           |   |
|               |   |   |   | Michael L. Paxton                               |
|               |   |   |   | Vice President, Chief  Financial Officer,       |
|               |   |   |   | Treasurer &  Secretary                      |
|               |   |   |   | (Principal Financial  & Accounting Officer) |

 

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